Tax Theory and Economic Analysis: General Economic Theory

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General economic theory holds that total welfare is maximized when social marginal benefits equal social marginal costs of production. Yet production may continue beyond this point if pollutants or activities generate unrecognized external costs. British economist Arthur Pigou theorized that taxes may correct for negative externalities, and help prices closely approximate marginal social costs. Pigou concluded that the optimal environmental tax rate will be equal to these unrecognized external costs, or marginal social damages. Abatement should be pursued until the marginal cost of additional abatement is equal to the marginal benefit of reducing pollution. This optimal tax rate is referred to as the “Pigouvian rate”, and causes an improvement in environmental quality as individuals and firms lower their pollution to avoid paying the tax.

Environmental taxes are generally more cost-effective than regulatory “command-and-control” approaches under a range of market conditions. That is, the total abatement cost for a given level of environmental quality will generally be lower under an environmental tax or charge than under regulation. The social cost effectiveness of environmental taxes, established in both economic theory and empirical analyses, is due in large measure to the flexible way taxes allow decisions over pollution to be made at the individual firm level.